Model Answer
0 min readIntroduction
Exchange rate management refers to a country’s policy framework for influencing the value of its currency relative to other currencies. The primary objective is to maintain external stability, facilitate trade, and promote economic growth. India has historically followed a managed float exchange rate regime, allowing market forces to determine the exchange rate while the Reserve Bank of India (RBI) intervenes to manage volatility and prevent excessive appreciation or depreciation. As of November 2023, India’s foreign exchange reserves stand at approximately $593.12 billion, a substantial amount, but the question remains whether the current regime is optimally contributing to their sustained build-up and effective utilization.
Objectives of Exchange Rate Management
The objectives of exchange rate management are multifaceted:
- Maintaining External Stability: Preventing large and disruptive fluctuations in the exchange rate.
- Promoting Trade Competitiveness: Ensuring the exchange rate supports export growth and discourages excessive imports.
- Controlling Inflation: A stable exchange rate can help anchor inflation expectations.
- Financial Stability: Preventing currency crises and maintaining confidence in the financial system.
- Facilitating Capital Flows: Managing exchange rate volatility to attract foreign investment.
India’s Present Exchange Rate Management Regime
India currently operates under a managed float exchange rate regime. This means:
- The exchange rate is primarily determined by market forces of supply and demand.
- The RBI intervenes in the foreign exchange market to moderate volatility, prevent excessive appreciation (which can hurt exports), and prevent excessive depreciation (which can fuel inflation).
- Intervention is typically done through buying or selling foreign currency (primarily US dollars).
- The RBI also uses capital flow management measures (CFMs) to influence exchange rate movements.
Assessment of the Regime’s Performance in Building Foreign Exchange Reserves
The present regime has had a mixed record in building adequate foreign exchange reserves.
Positive Aspects:
- Significant Reserve Accumulation: India’s foreign exchange reserves have increased substantially over the years, particularly after the 1991 economic reforms. From a low of around $5.9 billion in 1991, reserves have grown to over $593.12 billion (as of November 2023).
- Buffering Against Shocks: The substantial reserves have provided a buffer against external shocks, such as the global financial crisis of 2008, the Eurozone crisis, and more recently, the COVID-19 pandemic and the Russia-Ukraine war.
- Managing Volatility: The RBI’s intervention has been effective in managing exchange rate volatility, preventing sharp depreciations that could destabilize the economy.
- Improved External Sector Resilience: Higher reserves have contributed to improved external sector resilience, enhancing investor confidence.
Negative Aspects & Challenges:
- Sterilization Costs: RBI intervention to prevent appreciation often involves buying foreign currency and selling domestic currency. This increases the money supply, potentially fueling inflation. The RBI then has to ‘sterilize’ this by selling government securities, which incurs a cost.
- Moral Hazard: The perception that the RBI will always intervene to prevent depreciation can create moral hazard, discouraging businesses from hedging their foreign exchange risk.
- Competitive Devaluation Concerns: Some argue that India has, at times, intervened to keep the rupee undervalued to gain a competitive advantage in exports, potentially leading to trade tensions.
- Reserve Composition: While reserves are high, a significant portion is held in US dollar-denominated assets, making India vulnerable to fluctuations in the dollar’s value. Diversification of reserve assets is crucial.
- Recent Drawdowns: In 2022 and 2023, India witnessed a drawdown of foreign exchange reserves as the RBI actively intervened to defend the rupee against significant depreciation pressures caused by global factors like rising US interest rates and geopolitical tensions. This highlights the limitations of relying solely on reserve accumulation.
Comparison with Other Emerging Economies
| Country | Foreign Exchange Reserves (USD Billion - Nov 2023) | Exchange Rate Regime |
|---|---|---|
| China | $3,290 | Managed Float with Capital Controls |
| Japan | $1,180 | Managed Float |
| South Korea | $416 | Managed Float |
| India | $593 | Managed Float |
Compared to other emerging economies, India’s reserve levels are relatively comfortable, but the effectiveness of the regime is contingent on prudent management and diversification.
Conclusion
In conclusion, India’s present exchange rate management regime has been reasonably successful in building adequate foreign exchange reserves, providing a crucial buffer against external shocks and maintaining macroeconomic stability. However, challenges remain regarding sterilization costs, moral hazard, and the need for greater reserve diversification. Going forward, a more flexible exchange rate regime, coupled with deeper financial market development and prudent capital flow management, could enhance the effectiveness of exchange rate management and ensure sustainable external sector resilience. The RBI needs to balance the objectives of stability and competitiveness while adapting to a rapidly changing global economic landscape.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.